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© Daniel Carrasco
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In this third and final section, we will analyse how the behavior economic indicators determines the evolution of financial markets.
In particular, we will study the influence of economic indicators on interest rates, stock and share prices, and currency trading.
Therefore, we will focus our attention on the following three markets:
- Bond markets.
- Equity markets.
- Currency markets.
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Figure 3: The evolution of the economic indicators influences the evolution of financial markets.
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Index:
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| 3.1. Debt Markets. |
| 3.1.1. Interest rates set by the central bank. |
| 3.1.2. Interest rates of short-term fixed rate securities.
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| 3.1.3. Interest rates of long-term fixed income bonds. |
| 3.2. Equity Markets. |
| 3.3. Currency Markets. |
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3.1. Debt Markets.
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When you go to the bank to request a loan to purchase a car, a house mortgage, etc., it is of special importance to know the interest rates at that time and have an idea of how they will behave in the future to decide whether or not to go through with the deal.
When you go to the bank to deposit your savings in current or savings accounts, or in investment funds, you will be interested in knowing, similarly, what the interest rates are and how they will behave in the future to correctly decide the best destination for your money.
In this section, we will analyse some of the major interest rate determinants. In particular, we will try to understand the behavior of:
- Interest rates set by the central bank.
- Interest rates for short-term fixed income.
- Interest rates of long-term debt.
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3.1.1. Interest rates set by the central bank.
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When someone gets sick, they usually go to the doctor for a prescription which will improve their health. In the case of an economy, something similar happens. There are two entities, the state and the central bank, which can influence the course of an economy when it does not evolve according to plan.
The state can influence the behavior of an economy by fiscal policy, that is, altering the tax, public spending or transfers to families and businesses.
- If the state reduces taxes on family income, they will have a greater capacity to spend or save. This often results in an increase in private consumption and, therefore, higher economic growth.
- If the state is more generous with unemployment benefit or OAP pensions, the income of these groups will increase. This often translates into increased private consumption and better economic performance, at least in the short term.
The central bank can influence the economy through monetary policy, i.e. altering interest rates or the amount of money in an economy. A central bank can implement its monetary policy by
- changing the interest rate at which it lends money to domestic banks
- determining the interest rate at which individual national banks lend money to one another. Etc.
When the central bank modifies these rates (the official or reference rates), it obviously influences the interest rates which national banks decide to offer to, or demand from their customers in cases of deposit or loan.
Next, let us analyse the impact of a central bank change in interest rates on economic growth and inflation.
Situation 1: The central bank increases the official interest rate.
When a central bank increases the interest rate, financing gets more expensive due to the greater cost of borrowing money.
(i) Impact of an increased interest rate on economic growth:
- Families will buy fewer cars and homes. Therefore, it discourages private consumption, especially of durable goods.
- Companies will buy less equipment and structures (buildings, machines. . ) for use in future production. Therefore, it discourages business investment11.
Conclusion: A rise in the interest rate has a negative impact on the economic growth.
(ii) Impact of rising interest rates on inflation:
- Increasing the interest rate decreases the volume of loans granted. In this context, the banking system reduces its ability to create money.
Example: An individual requests a bank loan of 20,000 Euros to buy a car. The car salesman receives $20,000 and this sum is deposited in his bank. The bank uses this money to lend12 to another individual and so on. Thus, the banking system is able to expand the original €20,000 into additional deposits and additional money. Therefore, if the volume of loans granted is reduced, the ability of the banking system to create money decreases.
- If the money in the hands of individuals does not grow at a much quicker rate than the production of goods for sale, prices will stay under control.
Intuitive idea: Suppose an economy in which output grows at a 1% annual rate and the amount of money available to buy this production remains constant, i.e. more things to buy with the same amount of money. This situation, in principle, should limit any price rebound.
Conclusion: A rise in the interest rate helps to keep prices under control.
Figure 4: Impact of a rising official interest rate on growth and inflation.
Situation 2: The central bank reduced the official interest rate.
When a central bank reduces the interest rate, it cheapens financing as you pay less to borrow money.
(i) Impact on economic growth from a reduction of interest rate:
The impact is the opposite of the aforementioned case with increase interest rate.
Conclusion: A reduction in the interest rate has a positive impact on the economic growth.
(ii) Impact on inflation of a reduced rate of interest:
The impact is also the opposite of that discussed above for an interest rate increase.
Conclusion: A reduction in interest rate stimulates a rise in prices.
Figure 5: Impact of an official interest rate reduction on economic growth and inflation.
Therefore, a central bank can alter its monetary policy in two opposing directions:
- The central bank may raise official interest rates. In this case, we say that the central bank restricts its monetary policy. With this policy:
- Economic growth is affected negatively.
- Price stability is contributed to.
- The Fed may cut official interest rates. In this case, the central bank is said to have relaxed its monetary policy. With this policy:
- Economic growth is stimulated.
- A rise in prices is favoured.
Once we know how a central bank can influence the behavior of an economy, through the use of monetary policy, one must wonder about the objectives pursued by central banks. This is necessary to be able to anticipate which type of monetary policy will be carried out in different economic scenarios.
In reality, the objectives differ from one central bank to another. The Federal Reserve
(Fed) of the United States seeks to ensure sustained economic growth, low levels of unemployment and stable prices. The European Central Bank (ECB) has specific inflation targets and has assigned a secondary role the behavior of economic activity.
In any case, central banks seek to:
- Control inflation.
- Ensure sustained growth of the economy.
Therefore, a central bank will carefully study the evolution of economic growth indicators and price, to be able to decide what its monetary policy will be. It will also have to consider other factors, for example, the evolution of public accounts.
Next, let us consider two fictitious situations and discuss how the central bank would act in each of them, taking into account:
- The impact of one type of monetary policy or another can have on economic growth and inflation.
- The objectives to be achieved as a central bank.
Situation 1: Strong economic growth in danger of overheating, i.e. that prices will rebound significantly.
In this situation, the central bank would raise the official interest rate to try to contain inflationary pressures. The negative effect that such a decision would have on the dynamism of economic activity would not be too worrisome, since it originates from an initial situation of strong economic growth.
Situation 2: Economic slowdown and absence of inflationary pressures.
In this situation, the central bank would reduce the official interest rate with the idea of stimulating economic growth. The negative impact of such a decision on inflation would not be too worrisome either, since it originates from a situation where prices are under control.
The reality, however, may be more complex and there may be alternative situations in which it is more difficult for us to calculate how the central bank will act. This would be the case, for example, in a situation of economic weakness and high inflation, which is known as stagflation.
Graph 13 shows the evolution of the official interest rate of the U.S. Federal Reserve since 1999. During 1999 and first half of 2000, the Fed increased the interest rate in a context of strong economic growth and increasing inflationary pressures. Throughout 2001, however, the Fed significantly reduced the official interest rate when the economy was losing momentum and inflation was dropping. Interest rate decreases were heightened after the terrorist attacks of 11 September 2001. From mid-2004, after a long period with the interest rate very low levels, the Fed returned to an upward trend of the official interest rate due to increasingly solid economic growth and some inflationary acceleration.
Graph 13: Trends in the official interest rate from the U.S. Federal Reserve.
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3.1.2. Interest rates of short-term fixed rate securities.
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The evolution of the interest rate of short-term fixed rate securities (debt)14 is closely linked to changes in the central bank fixed interest rate.
The interest rate associated with this type of security will increase or decrease according to whether there are growing or decreasing market expectations about possible rises or falls in the official interest rate by the central bank. In this regard:
i) In an uptrending rate cycle, i.e. in a period when the central bank tightens its monetary policy by raising the official interest rate:
- When impressive economic growth data due to its strength or higher than expected data on increasing inflation is published, the market will increase its expectations about additional increases in the official interest rate. Therefore, the interest rate of short-term securities will also go up.
- When impressive data on economic growth weakness or inflation climbs less than expected, the market will reduce its expectations about additional increases in the official interest rate. Therefore, the interest rates on the short-term securities will decrease.
ii) In a downtrending rate cycle, i.e. in a period when the central bank is relaxing its monetary policy by lowering the official interest rate:
- When impressive economic growth data due to its strength or higher than expected data on increasing inflation is published, the market will decrease its expectations about additional falls in the official interest rate. Therefore, the interest rate of short-term securities will go up.
- When impressive data on economic growth weakness or inflation climbs less than expected, the market will increase its expectations about additional drops in the official interest rate. Therefore, the interest rates on the short-term securities will decrease.
In the evolution of short-term securities, there are periods in which the market expects the central bank to go way beyond what they really do. Figure 14 we can observe how, at the end of 1994, Two-Year U.S. bonds stood at levels consistent with the Federal Reserve raising the official rate beyond 6% which, ultimately, did not occur.
Graph 14: Fed official interest rate and the interest rates of Two-Year U.S. bonds.
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3.1.3. Interest rates of long-term fixed income bonds.
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The interest rate on long-term bonds can be interpreted as the geometric average of the interest rate expected for short-term bonds for the its total duration.
Thus, the development of long-term bond markets will also depend on economic growth and inflation behavior. The impact of these variables on the interest rate in this case will be similar to that already studied for short-term securities.
There are also other factors which will affect their development. Among these we highlight the following:
- Evolution of a country’s budget balance.
- Evolution of stack indices or risk aversion.
Figure 6: Factors determining the evolution of the interest rate of long-term bonds.
Now let's try to understand how these last two factors influence the evolution of long-term fixed income bonds as far as the supply and demand of such bonds is concerned:
- With increased demand for fixed-income bonds, its price tends to increase (rate of return decreases, in other words, the interest rate).
- When supply increases for a fixed-income bond, its price tends to decrease
(increases the internal rate of return increases, i.e. the interest rate).
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This relationship between the supply and demand of a fixed-rate bond and its price can equally be understood that if we consider the case of goods such as apples:
- When demand for apples increases (e.g. a virus has affected pears so, many pear consumers now choose apples) the price of apples increases to balance the supply and demand. The price increases, so fewer people are willing to buy apples.
- When the supply of apples increases (good climate factors have allowed an excellent harvest) the price of apples decreases to balance apple supply and demand. The price decreases and therefore a larger volume of apples is put up for sale.
Next, we'll explain the inverse relationship between the price of a fixed-income bond and the interest rate. On many occasions we can often read "bonds trending positively with important price advances (or, equivalently, reductions in the interest rate)” in our newspapers.
To understand this relationship we will use two very simple examples. In example 1, we see how money flows over time. In example 2, we calculate the current price of a bond taking into account example 1. From that calculation, we observe the inverse relationship between price and interest rate
Figure 7: Transfer of cash flow over time.
Example 1: Transfer of cash flows over time.
The top of Table 7 shows how we can displace present cash flow into the future. If, in period t = 0 we deposit 10 euros in the bank, in period t = 1 we have the 10 euros plus the interest generated by those 10 euros: 10 (1 + i).
At the bottom of table 7, all you do is reverse the order of top box, so that shows how to displace cash flow for period t = 1 to t = 0. The way to do this is to divide by the interest rate in particular by (1 + i).
Example 2: The calculation of the current price of a bond.
In figure 8, we have a three-year bond. Initially, to purchase this bond we have had to pay 100 euros. In return, there is a commitment to receive a 10 euros remuneration for each of the next three years and in the third, to recover the €100 initially disbursed. From this information, we calculate the current price of the bond by moving the future flow back to the initial period and, for this purpose, we use the technique presented in the previous example.
This calculation is shown in Table 8 and from the same, we can easily observe the reverse relationship between the price and the interest rate of a fixed-income bond.
Figure 8: Calculation of the current price of a bond.
When we say that bond markets have risen or fallen, or that the day finished (week, month,...) with a positive or negative balance, it is always done in relation to what has happened to the price of this asset, not what has happened to the interest rate associated. That is, if we say that the ten-year U.S. public debt bonds have risen or finished the day with a positive balance, this means that the price of the bond has increased and, therefore that the interest rate associated has receded.
At this point, let us understand how stock index behavior and the budget balance affect the interest rate of fixed-income bonds.
Stock Indices
On many occasions we read "The decline of the stock indices has supported bonds”. That is, referring to the price of shares to explain the surge in bond prices or, equivalently, the fall in interest rate therein.
When the stock exchange recedes, for example during an episode of risk aversion, agents take shelter in bonds. This translates into greater demand, leading to an increase in price and a fall in the interest rate associated with them.
Budget balance
The budget balance, as discussed above, is given by the difference between public revenue and expenditure.
If the state spends more money than its income (deficit budget), this difference must be financed somehow. One possible way is through the emission of debt bonds.
Therefore, when action is taken leading to an increase in deficit budget (increased defence spending, tax reduction on income, etc. . . ) bonds offering debt tend to increase. This translates into a decrease in price for this asset and an increase in the interest rate associated with same.
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3.2. Equity Markets.
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When investors buy Repsol or Telefonica shares, they usually do so because they trust
the prices will rise. In this section, we will study some of the elements that influence share price development.
Expectations for corporate earning will be, ultimately, those determining the evolution of stock and share prices. Therefore, we must focus our attention on the factors influencing these expectations.
In this sense we can distinguish between:
- Macroeconomic factors: those that affect the whole economy
and consequently, all the different companies.
- Microeconomic factors: those that affect a single company or group of
firms within the same sector.
Figure 9: The stock and share price is determined by microeconomic and macroeconomic factors.
Macroeconomic factors
Economic growth, interest rates and inflation will affect market expectations about corporate earnings.
- Economic growth: The better the growth prospects for a country's economy, the higher the expectations will be about future business sales and, consequently, their earnings.
- Interest Rates: The higher the interest rates, the more difficult low-cost finance will be for business investment projects. Expectations for corporate profits will plummet as financing cost increase.
- Inflation: The deterioration of inflation expectations is not often welcomed by the equity markets. On one hand, the investors will demand greater profitability to offset the reduction in real profit value, and on the other, the market may associate the deterioration of inflation expectations with monetary tightening policy, that is, higher interest rates.
In conclusion, the most benign macroeconomic scenario for equity markets is that which is characterised by good economic growth prospects, controlled inflation and low interest rates.
Microeconomic factors
The price of the shares for a company is also influenced by the intrinsic factors of the company itself or the sector to which it belongs. Among them we mention the following:
At company level:
- Management changes.
- Technological changes.
- Changes in the cost control process.
At sector level:
- Changes in competition.
- Legislative changes.
Graph 15: Effect of power station temporary closure on the price of Scottish Power shares.
Graph 15 shows the share price development of the electricity company Scottish Power. At the end of the year 2000, there was a sharp fall in the share price (first arrow in the figure) which was not due to macro but to micro factors. The fall came after the announcement of the temporary closure of a power station and the consequent necessity of having to buy electricity from another company at a higher cost. The decline in the share price simply reflected the negative impact this fact had on the future benefit of the company.
Graph 16 shows the evolution of the U.S. Standard & Poor's 500 Index since the early nineties.
The index developed very favourably to mid 2000, coinciding with a period of strong economic growth, significant productivity gains and controlled inflation. Since then, however, the rate began to recede. Brokers perceive that the expectations of future corporate profits were unrealistic. In addition, inflationary pressure was rising, interest rates were getting higher and leading activity indicators began to demonstrate a loss of dynamism in the U.S. economy.
The stock exchange fell during two consecutive years, in a period characterised by economic slowdown , bankruptcies and accounting scandals at some major companies. The geopolitical stage was also complicated (September 11 attacks - 2001, Afghanistan and Iraq wars).
Since 2003, the stock exchange started to become bullish accompanied by an expansion in economic activity, moderate growth rate and favourable financial conditions.
Graph 16: Trends in the Standard & Poor's 500 since the early nineties.
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3.3. Currency Markets.
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Commercial and/or financial transactions are conducted between dealers in the same country (or monetary union) using the same currency.
- When I buy the paper at the neighbourhood kiosk, I pay in euros. When I buy an ice-cream after work, I pay in euros, etc..
- When I buy Telefonica shares, I pay in euros. When I buy German bonds, I pay in euros, etc.
However, there are times when commercial and/or financial transactions are made between dealers in countries with a different currency. In these cases, there must be an exchange rate for the exchange to be able to take place.
- A Spanish company buying cameras from a Japanese company
must obtain yens in order to buy them.
- A Spanish investor who wants U.S. company shares must obtain dollars in order to buy these shares.
Buyers in international markets need to obtain the money (currency) of those countries in which they wish to buy property or assets (direct investments, portfolio investments, etc.).
Currency markets or foreign exchange markets are markets in which brokers will be able to exchange one currency for another. This exchange will be determined by the exchange rate.
Therefore, the exchange rate can be defined as the price of one currency in another. For example, if the exchange rate between the U.S. dollar and the euro is 0.97 dollars per euro, we can change one euro for 0.97 dollars in currency markets.
This price does not remain constant over time, but changes according to the conditions of supply and demand for different currencies19. In this sense, we can define two concepts:
Appreciation of a currency: a currency appreciates when it increases its value with respect to other currencies. For example, the euro appreciates against the dollar if
the exchange rate goes from 0.97 dollars per euro to 1 dollar per euro.
Depreciation of a currency: a currency depreciates when decreases value compared to other currencies. For example, the euro depreciates against the dollar if the exchange rate goes from 0.97 dollars per euro to 0.90 dollars per euro.
The evolution of the exchange rate, or the value of one currency against another, is not irrelevant. Here, we have two possible consequences the depreciation of a currency. To do this, we will use as the price of the euro against the dollar.
When the euro depreciates against the dollar:
- The competitiveness of European businesses in the U.S. increases.
European products become cheaper for American consumers.
- Inflationary pressures in the euro area arise from products imported from the U.S. American products are more expensive for European consumers.
Therefore, the depreciation of a currency usually has a positive influence on economic growth due to better performance abroad, and aggravated inflation from rising prices of imported products.
In this section, we will focus our attention on some of the factors which determining the evolution of the exchange rate between two currencies:
- Economic growth
- Interest rates
- Balance of Trade
- Inflation
Figure 10: Determinants of changes in the exchange rate between two currencies.
In this analysis we will consider the influence of each of these factors on the demand and supply of a currency:
- With increased demand for the currency, it tends to appreciate.
- When you increase the supply of a currency, it tends to depreciate.
To understand this correlation, and similarly to what we did earlier, in the study of bond markets in the long-term bond markets, we will use an example.
Example: Consider the trade relations between the United States, whose currency is the dollar and the Eurozone, whose currency is the euro.
To buy European products, U.S. consumers will need euros. Therefore, they will have to go to the currency markets and demand/buy euros in dollars (just as if they went to a supermarket to buy apples in exchange for dollars). Thus, by increasing the demand for euros, will increase their price, i.e. consumers will need increasingly more dollars to buy a euro (just as the price of apples rises with an increase in demand). Therefore, if the demand for euros increases, the euro will appreciate against the dollar.
To buy American products, European consumers will need dollars. Therefore, they will have to go to the currency markets and offer/sell euro in return for dollars (just as sellers of apples offer the supermarket apples in exchange for dollars). Thus, by increasing the supply of euros, its price will decrease, i.e. fewer dollars are increasingly required to get one euro (just as the price of apples falls with an increase in offer). Therefore, if the supply of euros increases, the euro will depreciate against the dollar.
Now we will analyse the impact of each of the factors mentioned previously (economic growth, interest rates,...) on currency rates. To simplify, we will focus on the euro dollar (EUR/USD).
Economic Growth
If the economic outlook for the Eurozone is better than that of the United States, one should expect, for example, more favourable development in the European stock exchange. In this context, the appeal of European shares for U.S. investors will increase. This means there will be an increased demand for euros by U.S. investors, to be able to purchase these shares. Therefore, further economic growth in the euro area should lead to the appreciation of the euro.
Interest rate
If interest rates rise more rapidly in the Eurozone than in the United States, European fixed income securities will have more appeal for U.S. investors. This translates as increased demand for euros by American investors to buy these securities. Therefore, in principle, higher interest rates in the Eurozone should lead to the appreciation of the euro.
However, it should be noted that a more rapid increase of interest rates in the Eurozone than in the U.S., does not always lead to appreciation of the euro. This can result in European currency depreciation if the increased interest rates in the Eurozone are interpreted by the market as an element which could choke economic growth.
Balance of Trade
The balance of a country's trade is given by the difference between exports and imports of goods and services.
When the Eurozone imports products from the United States, euros are offered in exchange for dollars to buy these products. Therefore, an increase of European imports should lead to euro depreciation.
When the Eurozone exports products to the United States, Americans demand euros in return for dollars to buy European products. Therefore, an increase in European exports should lead to an appreciation of the euro.
In conclusion, an increase of trade deficit in the Eurozone, i.e. a situation in which imports are greater than exports, should lead to euro depreciation.
Keep in mind however, that an increase in trade deficit in an economy should not necessarily translate into depreciation of its currency. Depreciation is produced when a country which has growing external imbalance finds it difficult to finance that imbalance. Otherwise, the currency does not have to necessarily lose value.
Inflation
One way to understand the impact of inflation on the conduct of a currency is by the correlation between inflation and competitiveness. Increased inflationary pressures in the Eurozone reduces the competitiveness of European products in international markets, while it increases the competitiveness of imported products in European markets. Thus, it is likely to harm exports and benefit imports. In this context, as explained previously, the euro would be damaged. Therefore, higher inflation in the Eurozone should lead to euro depreciation.
In conclusion, a currency tends to appreciate in a context of:
- Strong economic growth.
- High interest rates.
- Trade surplus.
- Reduced inflation.
Graph 17 shows the exchange rate evolution between the euro and the dollar since January 1999, at which time the euro began to be traded. Between 1999 and 2001, the dollar clearly appreciated. Investor confidence in the U.S. economy and the resulting appeal of dollar based assets led to an important net influx in the U.S.. Since 2002, however, the trend reversed. The external imbalance of the U.S. economy grew stronger, while the ability of its economy to attract enough cash flow to finance its massive trade deficit put into doubt.
Graph 17: Trends in the exchange rate between the euro and the dollar (dollars per euro).
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Macroeconomic Analysis 
